Quantitative Commodity Research

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Sunday, 13 July 2014

The major
fundamental factors in our fair value models for the weekly metal prices were mixed
this week. The major role played the outlook for US interest rates and stock
markets for the precious metals.

Base metals
were mixed but digested well the Chinese trade data, which showed a slower than
expected increased of Chinese exports of 7.2% yoy compared with a 10% rise
predicted by the consensus. Thus, the export surplus came in lower than
expected at $31.6bn. Analysts reported that the import of metal was already
affected by the probe of Qindao warehouses as banks are now more cautious with
providing letters of credit to metal importers.

As far as
US interest rates are concerned, two reports had an impact on markets. The
first was a forecast revision by the chief US economist at Goldman Sachs. It
took Mr. Hatzius a long time to wake up and to understand the messages, which
the FOMC sent out with the quarterly short-term projections and dot charts. The
message of the Fed was for quite some time that the first rate hike will take
place most likely in mid-2015. But Goldman Sachs predicted against all odds
that the first hike would not occur before Q1 2016. Now, also Goldman Sachs
forecasts the first increase of the Fed Funds target rate for 2015. As the Fed
prepared the markets for quite some time, this forecast revision should not have
had any impact on markets. However, traders and analysts argued that the US
stock market traded lower after the longer weekend due to the Goldman Sachs
forecast revision. Another hint that the Chicago school theory financial
markets are not information efficient is not worth a cent, neither an economics
noble laureate.

The second
report had been the minutes of the recent FOMC meeting, which were released on
Wednesday. The interesting news of the minutes is that the majority intends to
terminate the bond purchasing program with the October FOMC meeting. This
implies that the purchases of US Treasury paper will be reduced not at the
current speed of $5bn in October but by $10bn. However, ending QE3 by the end
of October 2014 has also implications for the timing of the first rate hike by
the Fed. Chair Mrs. Yellen stated several times that the first hike might take
place about 6 month after terminating the bond purchase program. Therefore, the
FOMC might decide already at the April 28 -29, 2015 FOMC meeting instead at the
on at the end of June next year to increase the Fed Funds rate.

If the FOMC
decides in April 2015 to hike the Fed Funds rate, then there are five more
meetings scheduled were the committee could lift the key interest rate to a
more normal level. Thus, also the level for the Fed Funds indicated by the dot
charts of 1.25% by the end of 2015 gets more likely. However, the Fed Funds
futures only price in a rate of 0.75%. From our point of view, fixed income
markets are currently too optimistic for the outlook of Fed Funds by the end of
next year. But adjusting expectations for the short-end will usually also have
an impact on the long end of the US Treasury curve. Thus, 10yr US Treasury
notes appear to be expensive at the current yield of 2.52%.

It might
still take some time until the fixed income markets realize that the implied
rate for the Fed Funds by the futures traded at the CME are too low compared
with the signals send out by the Fed. However, once the market starts to
correct its expectations, the potential impact on metal prices will be
negative. On the one hand, rising US interest rates and yields increase the
opportunity costs of holding metals. On the other hand, this development could
reduce the attractiveness of commodity financing trades in China and thus,
reduce the Chinese demand for metals used in commodity financing, which is not
only limited to aluminum and copper, but also includes precious metals.

But that
precious metals rose further during the past week, is the result of the “shoot
first and ask later” mentality among traders and investors. On Thursday, Espirito
Santo Financial Group (ESFG), which holds a stake of 25% in Portugal’s largest
bank Banco Espirito Santo (BES), decided to suspend trading in its shares and
bonds due to “material difficulties” at its largest shareholder Espirito Santo
International (ESI), which is controlled by the Espirito Santo family. After
BES shares fell by 19%, Portugal’s stock market regulator halted also trading
in BES shares. Rumors swirled through markets that BES were in financial
difficulties. As a result, not only the shares of BES and ESFG plunged, but it
dragged also the Portuguese stock market and also other markets in Europe and
the US lower. Furthermore, contagion spread also to the market for government
bonds of the Eurozone. Yields on peripheral bonds jumped and Greece was only
able to sell have the amount intended at an auction. The plunge of stock
markets and soaring yields on peripheral Eurozone government bonds triggered a
flight into save havens, which included also precious metals beside US
Treasuries and German Bunds. During Thursday night, BES declared that its
exposure to ESI would not put the bank at risk of running short of capital to
assure investors about its financial stability.

This declaration
led to a stabilization. However, according to reports published on Thursday, it
should have been clear, that the problems of ESI are institution specific and
not a general problem of the Portuguese banking sector in total. The flight to
safe havens might support these assets for some time as investors might prefer
to get more evidence that the Portuguese banking sector is not in troubles. Thus,
in the short-run, the precious metals might be well supported by the safe haven
status and as a mean to diversify the risk of holding equities. But the outlook
for the US bond market in the medium-term indicates that the all-time high is
far out of sight for gold and silver.

Sunday, 6 July 2014

Last week,
precious metals closed higher than the Friday before. However, all fundamental
drivers included in our fair value models were negative. But investors have
rediscovered commodities and the rise of some base metals also supports the
precious metals.

Among the
economic data, the focus was on the purchasing manager indices for many
countries. The Markit flash estimates prepared the markets already for weaker
PMIs for many countries in the Eurozone. Thus, it was not a surprise for the
market that the final index confirmed the trend, especially as also the EU data
on business confidence come in lower. In the US, the ISM manufacturing PMI also
edged lower while the consensus of Wall Street economists expected a small
increase. However, the lower ISM did not harm the recovery of the US stock
market as some components of the ISM manufacturing PMI pointed to better index
readings next month.

But not
each decrease of a purchasing manager index translates into weaker economic
activity. The first misunderstanding is the threshold level of 50. The PMIs are
so-called diffusion indices based on surveys. The percentage of negative responses
is subtracted from the positive ones. If the number of positive and negative
replies is the same, the raw index is zero and the value of 50 is added to
obtain an index oscillating around a positive number. However, the responses
are not weighted by the size of the company. Regression analysis between
economic activity and manufacturing PMIs show that the critical value is in
most cases below the 50 threshold.

Furthermore,
the time series properties of the PMI are different from those of financial
assets. The vast majority of assets in financial markets follow a random walk,
which could be described by a geometric Brownian motion. However, oscillating
indicators like the PMIs are mean-reverting and their behavior could be
described by an Ornstein-Uhlenbeck process. Even with a slow speed of
adjustment to the mean, declines during the phase of economic expansion occur and
are not necessarily already a harbinger of a slowdown.

In China,
the official manufacturing PMI remained above the 50 threshold. However, the
more widely followed HSBC manufacturing PMI fell below the 50 threshold in
January and now rose again above 50 in June. This surprise already provided
support for copper after the release of the flash estimate and lifted copper
further up this week.

The US
labor market data came in far stronger than predicted by even many optimistic
forecasters. The number of new jobs created rose to 288,000 and also the figure
for the preceding month was revised higher by 7K to 224,000. The unemployment
rate was expected to remain unchanged at 6.3% but dropped to 6.1%. And average
hourly earnings increased again by 0.2% on the month. Thus, the labor market
report points to an acceleration of the US recovery after the GDP drop due to
the weather in the first quarter. This has lifted the US stock market to new
highs for the S&P and Dow Jones indices. Also the US dollar appreciated
against the major currencies and the US dollar index rose. Furthermore, the US
bond market declined and yields on the 10yr US Treasury note rose by to 2.64%.
All these factors are usually negative for precious metals.

Stronger
economic data is normally supportive for the price of crude oil as it indicates
a rising demand. However, demand is only one side of the equation. It was developments
at the supply side, which lead to falling oil prices. In particular the news
that the Libyan government reached an agreement with rebels, who handed over
ports with oil terminals, send the price of crude oil lower.

In 2013 and
also in some parts of this year, a stronger US stock market was negative for
precious metals. The rise of the PGMs could be well explained with a stronger
economy, translating into higher demand from car makers, and the supply loss
due to the strike in South Africa. But why does gold and silver now rise when
the major fundamental drivers are negative?

First, correlations
are not causations and many factors can have an impact on the relationship between
two variables. This explains well, why correlations fluctuate widely if
correlation is measured over a shorter time period like 20 or 30 days. There
were also periods when the stock markets and gold moved in the same direction
before.

Second, the
behavior of investors is not constant. Their assessment of future performance
perspectives changes. Also the perception of risk is variable. In 2013,
investors were convinced that stock markets offer a better return outlook and
they shifted funds massively out of commodities into stock markets. The
precious and base metal prices declined from the levels prevailing at the start
of last year. However, now, two developments have changed the outlook. Many
investors get more cautious towards equities. The valuations do not look as
attractive compared to last year. Volatility has dropped. This is often
regarded as a sign of complacency by investors. However, fund managers are now
aware that low volatility spells danger.

Analysts at
the end of last year were predicting that supply of many metals would rise and
would shift the supply-demand balance towards lower prices on average in 2014.
In this blog, we pointed out for copper that the development of warehouse
inventories were not compatible with the narrative told by analysts but also official
organizations. Indonesia impost export regulations, which had a strong impact
on the supply of some metals. Nickel was the first base metal reacting with
rising prices. But also lead and zinc prices recovered during the first half.
Now also copper recovered and is trading again above the 7,000$/t level.

Therefore,
we conclude that an increasing risk-awareness towards equities and the improved
outlook for commodities has induced investors to allocate again more funds into
commodity markets. Unfortunately, the LME has delayed further the publication
of data comparable to the “Commitment of Traders” report compiled for US
exchanges by the CFTC. Thus, there is only data for copper traded at the CME
available for base metals. At the start of the year, speculative investors were
net long 10,363 futures contracts and by the end of the first quarter, this
turned into a net short position of 32,975 contracts. But during the second
quarter, the net short position was reduced significantly to 1,764 contracts as
of July 1st. In gold, the non-commercials were net long just 766
Comex gold futures at the start of June. Within one month, the net long
position rose to 40,299 contracts, the highest level since early December 2012.
Also the gold holdings of the SPDR Gold Trust ETF rose by almost 20 tons after
hitting a low of 776 tons in late May.

If our conclusion about the behavior of large
investors is correct, it has two implications for precious metals. First,
firmer equities are not a reason to sell gold as some investors also buy gold
as a hedge against the case that equities might reverse direction. Second, the improved
economic outlook for the US and China leads to more funds flowing back into
commodities. This is the kind of tight that lifts all boats. But as piano
player Sam sung in the famous movie Casablanca: “Those fundamental things
apply, as time goes by”. Thus, the stronger US recovery should lead to the
first Fed rate hike in the middle of 2015 and rising yields will support the US
dollar and weaken US Treasury paper. Both should weigh on precious metals and
other commodities in the medium-term.

Sunday, 29 June 2014

What
started in the copper market with the probe of alleged fraud at Qindao
warehouses in China now spreads to the gold market. Bloomberg reported on Thursday
that China’s chief auditor discovered 94.4 bn yuan ($15.2bn) were collateralized
by falsified gold transactions. Although already widely suspected by many
people, this was the first official confirmation that also gold is used in
Chinese commodity financing deals. Goldman Sachs reports according to the media
that up to $80bn false-loans may involve gold. Thus, the question is: how do these
false-loans influence the spot gold market?

To answer
this question, it is first necessary to analyze how commodity financing deals
work. There are two possibilities. In the first kind of commodity financing
transactions, the owner of the commodity uses warehouse receipts to get credit
from banks. The proceeds from this collateralized loans can be invested in
higher yielding assets before redeeming the debt. This transaction is only
economical if the return on the investment is higher than the interest rate on
the loan. Due to restrictions, this is currently the case for investments in
the Chinese shadow banking system.

The second transaction
involves the import of the commodity. The Chinese buyer places an order with a
foreign company to buy the commodity. Then the buyer applies for a letter of
credit from a lender, which is used to import the commodity. With opening the
letter of credit, the buyer obtains the consignment, which he can sell in the
domestic market. Again, the importer of the commodity can use the proceeds for
investing onshore before paying back the original loan. As many commodities are
traded internationally in US dollars, this type of financial deal involves
cross-currency transactions. Funding costs in US dollars are quite low and the
foreign exchange rate risk is limited due to the yuan exchange rate regime,
which allows only limited daily fluctuations. In addition, as long as the yuan
strengthens against the US dollar, the yuan appreciation even contributes to
the return in local currency for the Chinese importer.

In the
first type, if the loan is based on a falsified gold transaction, then the
warehouse receipt is a fake. This implies that the lender has made a loan but
the collateral is worthless. The lender could demand from the borrower to
provide the promised collateral. Alternatively, the creditor could cancel the
loan agreement and demand the repayment of the credit. For the borrower, it
might be probably easier and cheaper to liquidate the domestic higher-yielding
investment and to redeem the loan. Buying the gold in the spot market requires
to have the funds available to pay the seller. Obtaining a loan in this
situation is probably far more expensive. In addition, interest payments on the
original loan are still due.

Therefore,
the direct impact on the spot price of gold should be rather limited. Those who
obtained a loan based on false-gold transaction are more likely to liquidate
the investment and redeem the loan than purchase gold to provide the
collateral. However, the process of selling the higher yielding investments
probably leads to price pressures for those investments, which might induce
other investors to purchase gold as a safe haven.

In the case
of the second type of commodity financing transaction, there should be a discrepancy
between the gold import statistics and the volume of consignments. In
international trade finance, after a letter of credit was opened, the bank of
the exporter sends the documents to the bank of the importer. The importer’s
bank examines the documents, makes the payment to the bank of the exporter and
hands the documents to the importer. If the consignment is faked, the buyer of
the consignment will notice the fraud with a delay of only a few months if the
commodity never arrives at the port of destination. Furthermore, ships can be
tracked easily nowadays. Thus, the chances of discovering a falsified gold
transaction involving gold imports are higher. Therefore, it is more likely
that a faked gold transaction occurs with warehouse receipts instead of consignments.

In the case
of a falsified consignment, it is also rather unlikely that it will lead to a
higher demand for gold in the spot market. The buyer of the consignment would
have to prove who faked the consignment. This could be either the exporter or
the importer. Identifying the party who faked the documents is a time consuming
process. But even if the buyer succeeds to obtain a legal title against the
criminal party, it might be worthless in the case this counterparty went
bankrupt in-between.

While the amount of commodity financing based on
falsified gold transactions is impressive, the impact on gold prices should be
rather limited. Unwinding the financing deals does not involve buying or
selling gold as a necessary condition. However, other assets, i.e. those
purchased with the proceeds from commodity financing might come under pressure.
This is especially the case if lenders demand more and secure collateral or
terminate the loan agreement.

Sunday, 22 June 2014

While
precious metals traded sideways ahead of the FOMC meeting, the four metals
rallied as the US dollar weakened against the major currencies after the
meeting. Gold jumped above 1,300$/oz. and silver above 20$/oz. However, we
regard the reaction in the precious metals and foreign exchange markets as
overdone.

The FOMC
kept the Fed Funds target rate unchanged at 0.25% or lower and reduced the
total volume of bond purchases by another $10bn. This should not come as a
surprise. The Fed did not provide any hint that the majority of FOMC voting
members would accelerate the speed of tapering. Even with the committee recognizing
“that growth in economic activity has rebounded in recent months”, the stronger
growth compared with the first quarter is not a convincing argument to change
track in monetary policy. Also the improvement in the labor market is not
sufficiently strong enough to justify a faster termination of bond purchases.
The FOMC still regards the unemployment rate as elevated. Furthermore, the
committee states “inflation has been running below the Committee’s longer-run
objective, but long-term inflation expectations have remained stable”. Thus,
also the second target of the Fed does not provide a justification for reaching
the end of bond purchases faster than previously indicated.

The FOMC
also presented its economic projections. It lowered the projection for GDP growth
in this year from 2.8 – 3.3% to 2.1 -2.3%. At a first glance, this might look like
a major revision in expectations for the current quarter and the second half of
2014. However, for the GDP in the final quarter of 2014 to be 3% higher than in
the same quarter of the previous year, GDP has to grow at an average quarterly
rate of around 0.75%. But due to the negative weather, US GDP declined by 0.25%
quarter-on-quarter, which translates into a drop of 1.0% annualized. Taking
this decline into account, the revised projection still implies an average
quarterly GDP growth of around 0.75% for the other 3 quarters in 2014. Thus the
new projection neither reflects a more pessimistic nor more optimistic view of
the FOMC members on the underlying expansion of US economic activity. Also the
revisions for the unemployment and inflation rate are only minor.

There was criticism
that the decision to taper further by $10bn was inconsistent with the revision
of GDP projections. However, as shown, the FOMC has not changed the projection
for average quarterly growth for the remaining 3 quarters. Furthermore, the
revision of the GDP projection has led to accusations that the Fed would always
overestimate GDP growth. The FOMC presents a range of GDP growth, nevertheless,
there remains an imponderability in any forecast of a random time series. And
in the case of the Q1 GDP growth, the weather had a stronger impact on economic
activity than on average during the winter months. Even meteorologists did not
predict such a long cold period before the start of the winter season. Therefore,
the FOMC is not to blame for overestimating the GDP growth in Q1.

But also the
expectation of faster end of bond purchases are not rational based on the expectation
of a recovering US economy. The projections of the FOMC for the dual mandate
variable are only modified slightly. Also the underlying expectation for average
quarterly GDP growth remains almost unchanged. However, for terminating bond
purchases faster the FOMC would have to expect stronger economic activity than
previously assumed. Just forecasting a recovering after the decline of GDP in
Q1 is not sufficient.

The dot
charts are sometimes misinterpreted. But they give a good indication about the
direction of monetary policy and the possible Fed Funds target rate at the end
of the corresponding year. There is still no majority expecting a rate increase
in 2014. Thus, the middle of 2015 remains currently the most likely date for
the first rate hike. However, there appears to be no majority for increasing
the Fed Funds target rate beyond 1.25% by the end of 2015. The dot chart from
the March FOMC meeting showed that the majority did expect the Fed Funds rate
to be only lifted to 1.0%. Thus, the FOMC got a bit more hawkish as far as the
outlook for interest rates is concerned. But the Fed Funds December 2015 future
just prices in a hike to 0.75%.

From our
point of view, the risk is clearly that the FOMC might hike the key interest
rate more than the market prices in during the second half of 2015. This should
be supportive for the US dollar against the euro and the Japanese yen. However,
the Bank of England might increase the base rate earlier. But overall, the
indications provided by the FOMC do not support arguments for a weaker US
dollar. Thus, the FOMC policy outlook is also not positive for the precious
metals.

But there
is not only a danger for precious metals of the Fed monetary policy outlook for
2015 via the influence of the US dollar on precious metals. At the current
yield of 2.62% on 10yr US Treasury notes, there is hardly any downside
potential left unless economic conditions weaken surprisingly and would derail
the FOMC policy projections. A rise of the Fed Funds target rate to 1.25%
within the next 18 months should also lift yields higher at the medium- to
long-term maturity range. Given the outlook provided by the FOMC, 10yr US
Treasury yields in the range between 2.75 – 3.0% appear more appropriate and
2.62% looks as expensive. A rise of US Treasury yields also increase the opportunity
costs for holding precious metals. Thus, also the medium-term outlook for the
US Treasury market is a negative factor for gold and silver.

Therefore, we come to the conclusion that the
outlook for precious metals is not as positive as the market believes after the
FOMC meeting. As long as the US economy develops as the FOMC expects, the risk
for precious metals remains more biased to the downside. Only negative
surprises, which would lead to a change in the outlook for the Fed policy,
could make gold more attractive in the medium-term. However, geo-political
developments could lead to demand for gold and silver as safe havens. How the
situation in Iraq develops is hard to predict.

Sunday, 15 June 2014

It was a
roller-coaster week for the PGMs. After a government mediation failed to reach
an agreement between the unions and mining companies to end the longest mining
strike in South Africa, palladium rose further to 862.5$/oz. Thus palladium
traded higher than in late February 2011 and reached the highest level since
February 2001. Also platinum rose, but remained below the high of the year,
which was reached at 1,493.90$/oz on May 22.

However,
after reports emerged that a wage deal might be in reach, both PGMs came under
pressure and posted strong losses. It was a bit of buying the rumor and selling
the fact, but it is at the time of writing just a hope that the mining strike
will be over soon.

According
to GFMS, the demand for palladium exceeded supply in 2013 by more than one
million ounces. South Africa contributed 2.35 mil ounces to the total mine
production of 6.4 mil. Ounces. Scrap recycling added another 1.9 mil ounces to
the total palladium supply. With the long lasting strike, the mine production
in South Africa is expected to fall significantly short of last year’s level.
Thus, overall palladium supply should be lower in 2014 than in 2013. In late
April, GFMS estimated that 0.6 mil ounces were lost due to the strike. Thus,
when workers return back to work, the total loss could come close to 1 mil
ounces. At the same time, the recovery in the European automotive sector points
to an increased industrial demand. Therefore, the supply deficit might rise to
2 mil ounces or above.

From the
high reached last Wednesday, palladium lost more than 50$/oz. In the short run,
the price of palladium might retreat further. However, with the outlook for a
higher excess demand, palladium should be well supported.

One
question often asked was about the size of the price increase since the start
of the year. Many commentators had expected a stronger rally given the duration
of the strike. One possible answer is that palladium consumers hedged their
demand right in time with options. In this case, the short seller of the option
only needs to buy incremental amounts of palladium according to the change in
the option delta to remain hedged. Another possibility is that consumers
expected that prices would decline again after a wage deal is reached. They can
secure physical palladium by lending from holders of palladium inventories,
which do not need the metal for immediate consumption. These are mainly
financial institutions and investors.

The rise of
palladium to a new multi-year high had also a positive impact on gold and
silver. All four precious metal have a common usage in the jewelry industry.
Thus, they are to some degree substitutes. A rise of the price of one metal relative
to the others is increasing the attractiveness to use one of the other metals
as a substitute. Thus, the rise of the PGMs increased the attractiveness of
gold in the jewelry industry. This explains that the rally of the PGMs at the
middle of the week also pulled gold and silver higher. Also quantitative models
(VAR) show that there is a stronger link between gold and platinum prices and a
stronger link between silver and palladium.

Then the question arises, why did gold and
silver prices increased further while platinum and palladium plunged? From our
point of view, the answer is the recent geo-political developments in the
Middle-East region. With the ISIS terror group gaining control over Mosul and
moving towards Bagdad, the markets got surprised. Oil markets fear that the
rebels gain control over Iraqi oil exports. Stock markets fear a negative
impact on global growth and turned lower, with weaker than expected US economic
data being another reason for taking profits. Thus, gold and silver remained in
demand as a safe haven, while the PGMs sold off.

Sunday, 25 May 2014

Only less
than two months ago, the International Copper Study Group forecasted at its
semi-annual meeting in Lisbon that after four years of supply deficit, the
copper market would swing into a surplus. While the ICSG estimates that the apparent
refined copper consumption exceeded supply in 2013 by 282 thousand tons. For
this year, the ICSG forecasts a supply surplus of 405 thousand tons. This swing
in the supply/demand-balance by 687 thousand tons is due to an increase in mine
production, which leads also to a rise of refined copper output. For this year,
global mine production is expected to increase by 4.7% to 18,904 thousand tons.
Refined copper production is forecast to rise faster than mine production by
6.5% to 22,362 thousand tons. The global copper consumption is predicted to
increase by only 3%, which is less than global GDP growth, to 21,957 thousand
tons.

A swing in
the supply/demand balance of the magnitude predicted by the ICSG should be
reflected in the development of copper stocks. According to the recent figures
published on May 22, 2014, by the ICSG in the press release for the Monthly
Copper Bulletin, global copper stocks increased by a total of 102 thousand tons
in the first two months of 2014. Inventories held in the warehouses of the
three major exchanges (LME, Shanghai and CME) dropped by 25.2 thousand tons in
the same period, which is in a clear contrast to the estimate of the ICSG for
the first two month. Since March, the fall of inventories accelerated. Despite
some temporary inventory builds at some exchanges, copper stocks are currently down
228 thousand tons YTD. This plunge of copper inventories at exchange warehouses
since the beginning of March is in such an obvious contrast to what one would
expect given the forecast of a 405 thousand tons supply surplus.

Certainly,
copper inventories are not only held in exchange warehouses. Producers and
consumers of copper also hold inventories, but one would expect that these
holdings are more determined by economic activity and opportunity costs. If we
take this into account, it appears rather unlikely that producers and consumers
have increased their inventory holding by the amount to explain the difference
between the change in the supply/demand-balance and exchange warehouse
inventories.

Furthermore,
if producers hold more inventories, then one would expect that they also want
to hedge the inventories, especially when the majority of forecasters predict a
change in the supply/demand balance. This should lead to a considerable
increase of open interest and falling copper prices. However, when copper
reached its low of the year so far in March, the LME copper futures open
interest was up only 7 thousand contracts compared to the end of 2013. In
addition, copper at the LME remained in a slight backwardation in mid-March.
But copper prices were in contango at the Shanghai Futures Exchange. LME open
interest in copper futures rose far stronger since mid-March to more than 340
thousand contracts at the start of this past week. This rise in open interest
was accompanied by a recovery of the copper price. This argues that not
producers are hedging against further falling prices due to a supply glut but
consumers hedge future demand. However, this behavior would be only rational if
consumers doubt that forecasts of a supply surplus depressing prices are
correct.

The other
explanation is that the copper supply surplus is held in bonded warehouses in
China and had been used for financing deals. In April, we analyzed the
development of the copper price in Shanghai and the inventories held at SHFE
warehouses. In 2012 and 2013, a structural break took place and inventories at
SHFE warehouses rose stronger as a model based on the development between 2009 and
2011 would have predicted. However, this development had not a major impact on
the price of copper. Other factors explained the price development far better. It
could not be ruled out, that the higher SHFE warehouse inventories were the
result of stocks moved out of bonded warehouses.

Thus,
doubts remain that the excess production of refined copper was absorbed by
stocks held in bonded warehouses in China for serving as collateral in
financing deals. Furthermore, it could not explain the decline of stock held in
exchange warehouse inventories

While total
exchange warehouse inventories decayed since the start of this year, stock held
in LME warehouses declined by 195 thousand tons and remained almost unchanged
in CME warehouses. At SHFE warehouses, inventories rose until the plunge of
copper prices, and then also sunk from 213.3 to 92.7 thousand tons, which
translates to a fall of 33.2 thousand tons since the end of 2013. It had been
reported at the end of April that China’s State Reserve Bureau bought copper.
However, according to the sources of the reports, the SRB bought from bonded
warehouses. But this does not explain the fall of copper stocks at SHFE
warehouses, unless the SRB also bought silently since mid-March copper in huge
amounts held in bonded and exchange warehouses.

We have data for cancelled warrants only for LME
warehouses. At the LME, the free available copper stocks plunged to a mere
92,650 tons at the end of this week. This is the lowest level since early April
2008. Copper is in a backwardation at the LME and the SHFE, which indicates
that copper is tight and not abundantly available as estimates about a supply
surplus would suggest. Our quantitative model for global total refined copper
supply and consumption indicates that consumption would further exceed supply
in this year. Structural changes can have a significant impact, which
quantitative models do not incorporate immediately. Thus, we would not rely
solely on quantitative forecasting models. However, the development of copper
inventories in exchange warehouses, the backwardation and the results of the
quantitative model increase our skepticism that the copper market will swing to
a supply surplus in the magnitude forecasted by the ICSG.

Sunday, 18 May 2014

The
announcement of London Silver Market Fixing Limited that it will terminate to
administer the London silver fixing with the close of business on August 14,
2014, should not come really as a surprise. After Deutsche Bank already
declared to withdraw from the fixings of gold and silver, only two bullion
banks remained in the group conducting the silver fixing. When this decision
was made public by Deutsche Bank, FCA board member, Mrs. Tracey McDermott,
stated that the UK regulator could intervene if there were too few participants
left in the London silver fixing.

In the
media reports about the announcement, no reason was stated why London Silver
Market Fixing made this decision. However, it is quite easy to guess what the
major reason behind this move is. The risk of financial penalties by regulators
or pending lawsuits – especially outside the UK - just got too high. In the
USA, CFTC commissioner Bart Chilton called for investigations into the London
fixings for some time already without having provided any evidence for manipulation
of the London fixings or for misconduct by the bullion banks involved. Also the
head of the German watchdog BaFin, Mrs. Koenig, accused Deutsche Bank of
wrongdoing without presenting facts. The London fixing was discredited by
foreign regulators. But now, they made a disfavor to many producers and consumers
of silver.

In this
blog, we have pointed out a few times, that the fixings of gold and silver are
not comparable with the setting of the Libor benchmark rates. The London
fixings are a price discovery procedure, which is based on real trading
activities and not on estimates of what the market price might be. Furthermore,
the bullion banks do not know how their clients might change the quantities
they commit to buy or sell if a new price will be called in the fixing process.
In addition, the procedure applied in the London fixings had also been used in
the past at regulated exchanges.

The LBMA issued
the following statement: “As part of our role as the trade association for the
London Bullion Market, the LBMA has launched a consultation in order to ensure
the best way forward for a London silver daily price mechanism. The LBMA will
work with market participants, regulators and potential administrators to
ensure the London Silver Market continues to serve efficiently the needs of
market users around the world. As part of the consultation process, the LBMA
will be actively approaching market participants requesting feedback.”
Furthermore, the LBMA conducts a survey in the process of market consultations.
Thus, the current system of price fixing in the silver market is coming to an
end, but the search for an alternative system is taking place already.

What might
be possible alternatives to the current London silver fixing? Silver is also
quoted by many financial institutions on quote screens at Bloomberg or
ThomsonReuters terminals or electronic foreign exchange trading platforms. One
possibility would be to use those quotes sampled at a random time within a
specified time span. Thus, traders would only know the time span, but not the
exact time stamp. Then the quotes in the lower and the upper 25% percentile
could be discarded and from the remaining quotes the average would be published
as the new benchmark indication. However, such an approach would have the same
weaknesses as the Libor benchmark procedure.

From our
point of view, any substitute for the current London fixings should be based on
real trades and not on quotes. Liquidity in the market is not the same at every
point in time but varies during the day. Thus, a new reference price should be
found when the liquidity is usually high in the market and this is the case in
the afternoon London time. Furthermore, a new benchmark price should be found
by trading taking place at one central location. In addition, the price should
be set in an auction style procedure.

Spot trading in precious metals is usually OTC
trading, but for the fixings, it is concentrated at one place where the price is
discovered in an auction style procedure. If the current system has to be
replaced without abandoning the advantages of high market liquidity, supply and
demand concentrated at one location and auction for price setting, then moving
the fixing to a regulated exchange is probably the best solution. This could be
an electronic exchange but also an open outcry system. The LME is already fulfilling
the requirements for a fair and transparent price setting for cash and forward
transactions in base metals. There are ring sessions with settlement prices for
transactions in the morning and afternoon. Moving the London fixings of
precious metals to the LME ring trading might be the best alternative.
Producers and consumers would be able to obtain the best price for larger
quantities in trades at a regulated exchange. The procedure would be
transparent and the precious metals market would still have benchmarks satisfying
the requirements for reflecting the true market price.

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About Us

Before founding QCR - Quantitative Commodity Research Limited in June 2007, Peter Fertig worked over 20 years in the research department of Dresdner Kleinwort. His field of activity there incorporated fixed-income securities, he analyzed the major government bond markets and developed corresponding investment strategies. He was Chief Fixed Income Strategist at Dresdner Kleinwort and joint responsibility for the flagg-ship publication "Ahead of the curve". Finally, he covered as a strategist, commodity markets, focusing on precious and base metals. Within that framework, he gave presentations to institutional investors worldwide as central banks, insurance companies and pension funds as well as for corporate customers of the investment bank. Mr Fertig also commented on market developments in TV interviews. He is still interviewed by Reuters and Bloomberg.